This is a blog of essays on public policy. It shuns ideology and applies facts, logic and math to economic, social and political problems. It has a subject-matter index, a list of recent posts, and permalinks at the ends of posts. Comments are moderated and may take time to appear. Note: Profile updated 4/7/12

25 June 2011

Thinking Outside the Box: A Zero Capital-Gains Tax

Ah! That got your attention, didn’t it? Coming from a blogger who castigated the President for extending the Bush tax cuts for the rich, it’s a head snapper. A zero tax rate? Am I out of my mind?

I don’t think so. Read on.

The impetus for this idea is something that’s been troubling me for forty years. And it has nothing directly to do with the deficit or the impending catastrophe of a possible US default.

China has its five-year plans. We have our quarterly reports. If you knew nothing else about our two societies, you would predict that China would win.

And you’d be right. In real life, winning is all about planning and delayed gratification, or what I called in a previous post “second-piece waiting.” Repeated studies show that children who wait for a second piece of candy, rather than greedily devouring the first, fare better in every measure of their later life, from successful marriages to lifetime income.

We Americans are losing our lead, our “American Dream,” our standard of living and our way of life because the people who matter among us can’t think beyond the next bonus, quarterly report, or two-year election cycle.

We can’t do much about the election cycles. Our straightjacket of a written Constitution, about which our schools tell us to be so proud, has tied us in knots.

But we all know that government doesn’t matter much anymore. It’s perpetually deadlocked, and its “debates” have become little more than verbal mud wrestling. The private sector is where the action is. It’s certainly where our jobs and economic recovery are mostly likely to come from. So maybe if we can get our private sector thinking beyond 90 days, we can start to compete with the EU, let alone China, India and Brazil.

How do we do that?

Well, the current rage in economics is incentives. If you give people the right incentives, they will do right. If you give them the wrong ones, they will screw up.

The Crash of 2008 proved the latter proposition perfectly. The bankers who made predatory loans, the borrowers who took them, the investment bankers who packaged them, and the agencies that rated them all had perverse incentives, including obvious conflicts of interest. The result was a near-meltdown of the global economy, which we barely avoided by piling up all the debt we’re now fighting about.

But suppose you could change all that. Suppose you could give every business, investor and even investing consumers a strong economic incentive to think long term, to wait for that second piece of candy. And suppose you could do it with a simple change in law that any high-school graduate could understand. Wouldn’t you at least consider it?

To understand how the change would work, you have to understand a few things about our income-tax system. There are two kinds of income, which we tax at vastly different rates. The first is so-called “ordinary income.” It includes most of the money that ordinary people make: wages, salaries, and the earnings of independent contractors for their labor (for example, doctors’, lawyers’ and accountants’ fees). Ordinary income also includes most dividends from stock ownership and interest from bank and brokerage accounts.

The second type of income is called “capital gains.” It comes from investment. When you buy and later sell an investment, your gain or loss from the round trip (purchase and sale) is a “capital gain” or “capital loss.” The investment can be stock, bonds, real property (except for your own residence), precious metals, oil, or other commodities.

The difference between “ordinary income” and “capital gains” is not the really big one. For most purposes, our tax law treats capital gains much like ordinary income, as long as the investment lasts for less than one year.

But if the investment lasts longer than this one-year so-called “holding period,” we tax any gain at a much lower rate. For example, here is a comparison of the maximum (top bracket) ordinary-income tax rates and long-term capital-gains tax rates for the years 1954, 1980, and 2011:

As you can see, the differences in the top tax rates are huge, although they have been getting smaller over the last 50-plus years. (In comparison, the whole fight over the Bush tax cuts is about a few percent.) Why the difference?

Well, ordinary income is stuff you get personally and normally hoard or spend on yourself. If you’re poor or middle class, you spend it on necessities. If you’re rich, you spent it on luxuries, things like expensive clothes and jewelry, multiple homes, luxurious travel, yachts and private planes, and so forth. But in either case, you spend it on yourself and your family. It’s “personal” income.

But capital gains are different. That’s money you make from investments in your own or someone else’s business. It’s gain from money you put to work. In the best case, it creates jobs and business opportunities for others and wealth that never existed before.

The holding period, not the distinction between ordinary income and capital gains, is the key. You can make short-term capital gains by buying and selling a stock or option in a single day. In fact, with programmed machine trading today, you can make short-term capital gains in a millisecond. We tax those short-term gains much like ordinary income.

To make long-term gains and get the much lower tax rate, you have to hold the investment for a year or more. So the different tax rates, coupled with the holding period for capital gains, create a powerful economic incentive to invest in jobs, new wealth and opportunity for others and to hold that investment for a while.

The trouble is that a single year isn’t much time today. It goes by so quickly. New businesses barely get off the ground and organized in that time. A radically new product needs more time to gain market acceptance. A difficult R&D project requires much more time to prove itself. Look, for example, at how many years it has taken for Boeing’s 787 “Dreamliner” to approach the skies; and it’s still not there yet.

So if we wan’t to give business—which is the driving force of our economy and our society—a real, solid incentive to think long term, we have to increase the holding period for long-term capital gains. If we want to match the Chinese and their five-year plans, we ought to raise it to five years.

Now I can already hear business people screaming. They aren’t in business to give away something for nothing. So what do they get in return for a much longer holding period for favorable tax treatment?

Well, if we want to strengthen their incentive to think and invest long term, the best thing to do is to increase the differential between the top ordinary-income rate and the top long-term capital-gains rate. In other words, we make long-term capital gains even more (much more!) attractive than at present, as compared to ordinary income.

We can do that in three ways. We can raise the top ordinary income rate, for example, by refusing to renew the Bush tax cuts when they expire. We can lower the long-term capital-gains rate. Or we can do both.

My own thought is that we should do both. As you can see from the table above, the top ordinary-income rate is much lower than it has ever been in our postwar boom period. That’s what people like me have been screaming about. Raise the top ordinary-income rate, and we provide tax revenue to honor solemn pension and health-care promises and keep the safety net strong for future generations. At the same time, we reduce the amount that rich people waste on excessive personal consumption, as distinguished from investing in jobs.

But when you also lower the long-term capital-gains rate, you provide a strong incentive for everyone, including the very rich, to put their money to work.

If you do both, you say to rich and poor alike:

”We don’t care how rich you get. We want everyone to get rich. But we want you to get rich the right way, by building businesses that create jobs and wealth and making everybody better off. And we all know now you can’t do that overnight, except by gambling or swindling.”

”If you make your money by being patient and building something lasting, we’ll tax you lightly, maybe even not at all. But if you take income for yourself, right away, we’re going to tax you harshly. You’ll just have to wait for that second piece of candy.”

Isn’t that approach, after all, what built our postwar prosperity and the American dream in the first place?

So here’s the deal. The top “personal” tax rate goes up to 70% or so, where it was before the so-called “Reagan revolution.” The long-term capital gains rate comes down hard, maybe to zero, but only for investments held for five years or more. The result will be the strongest economic incentive in thirty years to put money to work and think long term, rather than go for the quick buck and hoard it or spend it on luxury.

The Congressional Budget Office will have a hell of a time “scoring” this proposal. Why? Because if it works the way we expect, it will restructure our whole economy. It’s not just rearranging the deck chairs on the Titanic. It’s building a whole new ship.

People who want lower taxes, which is almost everyone, will get them by investing their money in creating jobs and making our economy grow and our society richer. And because they have to hold their investments for five years or more to get the lower rate, they will start to think long term, just like the Chinese.

The precise numerical effect of these paradigm shifts will be hard to predict. But we don’t have to have exact numbers. We know this approach works because an earlier version, with a shorter holding period, built our postwar prosperity and the richest consumer society the world had ever known. Maybe we can even fold this revolutionary thinking into our budget deliberations and save ourselves from the economic equivalent of a nuclear holocaust—a default of the full faith and credit of the world’s leading economic power.

6 Comments:

There is a problem with your proposal. Those seeking to profit from a 0% tax rate can buy land at a low price, wait until they can get a much higher price in five to ten years, then get a large profit tax free without work and with very little risk. In other words what is called "capital gains" are in fact economic rents. Real capital gains happen in short time frames because capital depreciates over long time periods.

First, the second and forth sentences are mutually contradictory. Read them carefully and you'll see what I mean.

Second, whether "capital depreciates over long times periods" depends on its form. Cash might depreciate due to inflation. But real property normally appreciates with time, as your second sentence asserts.

More important still, I disagree that "[r]eal capital gains happen in short time frames." Lucky day traders can make "capital gains" by buying a stock low and selling it high on the very same day. But I wouldn't call that a "real" capital gain.

Our tax code agrees. It classifies that gain as short term, taxing it the same as ordinary income, at a higher rate.

Real capital gains, i.e., long-term gains, require effort, whether on the part of the investor or others. For example, someone might invest in land for a mine based on nothing more than a geologist's report. That's a risky bet because the geologist might be wrong. The investor then has to put in more money and effort to hire workers, dig the mine, and bring up the ore. If there's a lot of ore, the mine can become quite valuable. But on the normal scale of things today, that's unlikely to happen in a single year.

Land is another example. It might appreciate due to nothing more than population pressure. But land appreciates far more when someone invests in an improvement on it, such as a house or factory, or near it, such as a subway or housing development.

I have personal experience with the difference. I've owned a small partnership stake in bare land in Southern California for over twenty years. My profit? Less than 15%. Why? Because the land is still empty. Predictions that a city would surround it didn't come true.

Your second sentence is partly right. Capital assets can appreciate over long time periods. But that nearly always happens only because investors take risk and put money and effort into the asset.

My proposal is designed to make sure that investment and effort are for the long term. The reason is something that only experience and age teach well: long-term investment usually produces more gain both for the investor and for society.

The Chinese, including Chinese Americans, call long-term investment "patient money." It's something we Americans used to understand but have forgotten in our universal urge to get rich quick. That's one reason why China is beating us only almost every measure of economic improvement.

All income originates from three sources of production, labor, land, and capital. Wages are the return of labor, rents are the return of land, and interest (what "capital gains" should mean) is the return of capital. If you store capital hoping to profit from it later it will rust, decay, or require maintenance as well as need to be stored. I should also note that money, stocks, and bond are no more capital than a deed is land. I recommend that you read "Progress and Poverty" by Henry George.

Capital cannot return rent it can only return interest just as land cannot return interest it can only return rent. Money, bonds, and stock should not be considered capital because none of these are used in production they can only be used to acquire the land, labor, and capital that are needed for production. This is explained more clearly in "Progress and Poverty" by Henry George. I should also note that I consider the New York Stock Exchange to be more of a casino than a market.

You sound as if you are trying to learn economics and business from a single book, and one written 132 years ago at that! You can't do that. Virtually all of modern quantitative economics arose after George's book. You might as well read Marx and Engels.

I'm going to just make three points; then you're on your own. You're just going to have to read more, read more recent works, and look at the world around you in the news.

1. Words can have different meanings in different contexts. They often do. The word "capital" meant something far different to George (as well as to Marx and Engels), than it does today. Today all forms of money are considered "capital" because they can be converted into land, plant, labor, etc. through markets. As for the term "capital gains," I didn't make it up. It comes from our tax code, where it has been used for over 70 years. It is now common parlance in economics and business, and every person who runs a business knows what it means.

2. Your understanding of returns on capital is missing the concept of risk. That idea is absolutely central to understanding modern economics and business.

What justifies returns on capital, in modern economic theory, is not just the past labor in acquiring it, but the risk entailed in deploying it profitably. You may think that rent on real property, such as an apartment building, is risk free. But, in reality, it's not. The building could catch fire; the tenants could trash it; or a commercial or industrial development next door could kill its value by making it an undesirable place to live.

And residential real property is, as your references to "rent" suggest, probably a low-risk form of capital. What about someone like T. Boone Pickens, who invests hundreds of billions of dollars in "wind farms" to generate electricity. The oil- and gas lobbies think he's crazy. If they're right, Pickens or his heirs (he's very old) may lose everything. If he's right, they'll win big. That's risk taking; it's what drive innovation and progress in technology and industry.

3. Henry George did not fix the English language when he wrote "Progress and Poverty" in 1879. The English language and the science of economics have made considerable progress since then. You should, too.

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About Me

This blog reflects a quarter century of study and forty years of careers in science/engineering (7 years), law practice (8 years) and law teaching (25 years). A short bio and legal publication list appear here. My pre-retirement 2010 CV appears here.
As I get older, I find myself thinking more like an engineer and less like a lawyer or law professor. Our “advocacy” professions—law, politics, public relations and advertising—train people to take a predetermined position and support it against all opposition. That’s not the best way to make things work—which is what engineers do.
What gets me up in the morning is figuring out how things work and how to make them work better, whether they be vehicles, energy systems, governments or nations.
This post explains my respect for math and why you’ll find lots of tables and a few graphs and equations on this blog. If you like that way of thinking, this blog is for you.